Governments have four main ways to cut a negative externality. Each moves output towards the social optimum in a different way.
Four ways to correct it
Indirect or carbon tax
Add the external cost to the price, so producers or buyers pay it.
Tradable permits
Cap total pollution; firms buy and sell the right to pollute.
Legislation and regulation
Ban it, or set limits and standards, with fines.
Education and awareness
Warnings and campaigns change what people want to buy.
The points to remember
- Taxes and permits are market-based: they put a price on the harm.
- Rules and education change behaviour directly.
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Start with the tax, the policy most papers ask about.
Our example (made-up numbers)
| No tax | Tax of €4 a tonne | |
|---|---|---|
| Output | 40 | 20 (the optimum) |
| Welfare loss | Yes | None |
| Tax revenue | €0 | €80 |
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Remember it as: Tax the harm and the market finds the social optimum.
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Tradable permits put a cap on pollution and let the market set its price.
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Which policy, when?
| Policy | Strength | Weakness |
|---|---|---|
| Carbon tax | Revenue; firms choose how to cut | Hard to set the right rate; regressive |
| Tradable permits | Pollution is capped for sure | Permit prices swing; needs monitoring |
| Regulation | Simple and certain | Costly to enforce; no reason to do better |
| Education | Tackles the cause; lasting | Slow; can be ignored |
Paper 1 asked this in May 2025, as part (b) for 15 marks; May 2026 asked whether taxes, or carbon taxes, are the best fix.
Using real-world examples, evaluate the view that indirect taxes are more effective than education in reducing the consumption of demerit goods.
Model answer plan
See the answer broken into clear points, with guidance on how each point earns marks.
Animated graph
Watch the graph build step by step in study mode.
What the diagram must show
- Axes: costs and benefits, Q; MPB, MSB below it, S = MPC.
- Qm and Qopt and the welfare loss.
- The tax shifting supply up, or education shifting MPB down, towards Qopt.
How the 15 marks are given
| Marks | What your answer needs |
|---|---|
| 13–15 | Theory fully explained, terms right all the way through, balanced evaluation, real examples fully developed to support the argument |
| 10–12 | Theory explained, terms mostly right, evaluation mostly balanced, real examples developed |
| 7–9 | Theory partly explained, some evaluation but one-sided, examples partly developed |
| 4–6 | Theory only described, evaluation superficial, examples only named |
| 1–3 | Theory stated but not relevant, no evaluation |